Policy cooperation, incomplete markets and risk sharing
Charles Engel
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Comments:
Linda L. Tesar
Council of Economic Advisers
Jacques Polak Annual Research Conference, IMF
November 13-14, 2010
The call for policy coordination
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Issue:
- increasing calls for policymakers in advanced countries to internalize the
effects of their policies on emerging markets
- as globalization continues, spillovers larger and therefore motivation for
coordination greater
Two contributions of this paper:
- develop a simple model that highlights one form of externality
- studies the model under different degrees of financial market completeness,
can see the effect of financial market integration on magnitude (and direction)
of spillover
Message:
- the benefits of policy coordination depend on the nature of the externality and
on the extent of financial market integration
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Model
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A relative of a familiar friend: Cole and Obstfeld (1991)
Static model
Two countries: H, F
Each specialized in a distinct good: Y and Y* produced with labor
Uncertainty over productivity: A, A*
Trade in financial assets.
Complete markets = trade in contingent claims that pay a unit of the good
conditional on a pre-specified state k.
Incomplete markets = financial autarky. No trade in financial assets; trade in goods
occurs after the state of nature is realized.
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Specification of Utility
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1
𝑈=
∑ 𝜋𝑗 𝐶𝑗1−𝜎 − ∑ 𝜋𝑗 𝑁𝑗
1−𝜎
𝜔 1−𝜔
where 𝐶𝑗 = 𝐶𝐻,𝑗
𝐶𝐹,𝑗
If preferences were identical in the two countries ( = *) then any change in
productivity is exactly offset by a change in the terms of trade, so that income is
constant.
Allocations under financial autarky = allocations under complete markets
In this paper, consumers have home bias in preferences. When A increases and Y
increases, TOT deteriorate.
Substitution effect (H goods cheap) – large with home bias
Income effect (wages up and more Y to sell) – moderated by trade in financial
assets
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Unilateral (non-cooperative) behavior
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Since the home country has a monopoly over good H, it can maximize its welfare
by manipulating the terms of trade. Assume that the policy target is to maximize
consumption (could alternatively maximize output, or minimize labor, maximize
trade, etc.)
When A change, subsidize/tax labor, to moderate the change in supply, smaller
changes in TOT, mitigate the substitution and income effects.
When markets are incomplete, government wants to manipulate TOT.
When markets are complete, households are insured against some of the
consequences of TOT changes, and so policy is directed at the real exchange rate:
Ratio of home wealth to foreign wealth (inclusive of dividend payments) /*
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Cooperative behavior
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Problem is to maximize joint welfare of H and F, therefore internalize the terms of
trade.
Now degree of market completeness doesn’t matter – no benefit to manipulating
/*
Could have posed this an alternative way: Is there still a need for cooperation if
markets are complete? If households can fully insure, then the effects of
government policy may be neutralized.
What is more likely? That governments successfully coordinate to internalize all
externalities, or financial markets develop to insure the risk associated with such
externalities?
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Government policy and risk
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In the set up here, policymakers commit to a policy before state-contingent claims
are traded.
“… it is difficult to conceive of the opposite timing – that asset markets open before policymakers
commit to a policy… then agents would have to assign probablilities that the policymaker would
adopt certain policies. It is not easy to see how that could be modeled.”
But isn’t that the world we live in? We are subject to the risk of technology and the
risk of government policy (some of which will covary with technology).
Fortunately, this problem has been tackled before.
Lucas (1976), Cooley, LeRoy and Raymon (1984): The assumption of rational expectations
requires that the stochastic process for policy be specified as part of the environment of
constraints under which households maximize utility.
Lucas: investment tax credits
Cooley et. al.: monetary policy
Stockman and Dellas: tariffs
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Government policy and risk
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Stockman (1988) “Fiscal policies and international financial markets” presents
examples where the impact of government policy in an open economy is altered by
the existence of international financial markets. Some general lessons:
 financial markets can eliminate the income effects of policies (alter the s) but
cannot undo the substitution effects (see also Stockman and Dellas (1986))
 specification of the environment (policy and technology) and the set of
available assets matters. Can make the general statement that financial markets
affect the allocation of goods in equilibrium, but can’t generalize exactly how.
This may mean that the extension of the intuition from the real model with a
TOT externality to a monetary model is not entirely straightforward.
 If some financial assets are “missing”, the reason they are missing probably
matters for equilibrium allocations.
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Other considerations
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Dynamics
- reputation
- self-insurance – in response to risk, household’s may build up precautionary savings, neutralizing
the effect of policy.
- other margins – trade off between intertemporal price and intratemporal prices (see e.g. Costinot,
Lorenzoni and Werning, “A theory of capital controls as dynamic term-of-trade manipulation,”
(2013))
Asymmetry
- two country framework is a good start, but if the problem is spillover to many small countries,
makes the problem of even a benevolent big country difficult
Quantitative importance
- what are the magnitude of the spillovers? Do the size of the externalities justify the cost of
coordination?
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Bottom line:
- intuition about spillovers and financial markets is unlikely to carry over across specific contexts.
Need to write down the model that delivers the specific externality (reverse capital flows, exchange
rate appreciation, asset price volatility), the exact policies that operate on those externalities, and
the financial assets that agents may trade to hedge risk.
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